CHAPTER

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15PROFITS, MARKET STRUCTURE, AND MARKET POWER

Learning Objectives

After reading this chapter, students will be able to

• describe standard models of market structure,• discuss the importance of market power in healthcare,• portray bargaining between insurers and providers,• calculate the impact of market share on pricing,• apply Porter’s model to pricing, and• discuss the determinants of market structure.

Key Concepts

• If the demand for its products is not perfectly elastic, a firm has some market power.

• Most healthcare firms have some market power.• Having fewer rivals increases market power.• Firms with no rivals are called monopolists.• Firms with only a few rivals are called oligopolists.• More market power allows larger markups over marginal cost.• Barriers to entry and product differentiation can increase market power.• Regulation can be a source of market power.• In the United States, prices depend on bargaining between providers

and insurers.

15.1 Introduction

What distinguishes highly competitive markets (those with below-average profit margins) from less competitive markets (those with above-average profit

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Economics for Healthcare Managers238

margins)? An influential analysis by Porter (1985) argues that profitability depends on five factors:

1. the nature of rivalry among existing firms,2. the risk of entry by potential rivals,3. the bargaining power of customers,4. the bargaining power of suppliers, and5. the threat from substitute products.

Porter’s model explains profit variations in terms of variations in market power. Firms in industries with muted price competition, little risk of entry by rivals, limited customer bargaining power, and few satisfactory substitutes have significant market power. These firms face relatively inelastic demand and can get large markups. In contrast, even though entry is usually limited in healthcare, other firms face much more challenging markets. For example, a recent study (Upadhyay and Smith 2016) noted that over a three-year period, one group of hospitals in Washington consistently had a negative operating margin while another group had an operating margin higher than 10 percent. To help understand these differences, this chapter will use the Porter framework to explore links among profits, market structure, and mar-ket power.

Three characteristics of healthcare markets reduce their competitive-ness. First, many healthcare markets have only a few competitors, which mutes rivalry. Second, this muted rivalry can persist because cost and regu-latory barriers limit entry. Third, many healthcare products have few close substitutes. This lack of close substitutes makes market demand less elastic and may make the demand for an individual firm’s products less elastic. These factors give healthcare firms market power.

In addition, consolidation has been proceeding apace for more than 20 years, and it continues unabated. More than 550 hospital mergers or acquisitions took place between 2010 and 2015 (American Hospital Associa-tion 2016), and increasing numbers of physicians are becoming employees of hospitals or health systems.

These trends represent significant changes in healthcare markets. In the United States, healthcare prices result from bargaining between insurers and providers, so the market positions of both matter. An insurer with a small market share will typically be forced to pay higher prices to providers. Like-wise, a health system with a larger market share can usually negotiate higher prices, especially if it offers services that rivals do not (Roberts, Chernew, and McWilliams 2017).

Profit-oriented managers will usually seek to gain market power. The most ambitious will try to change the nature of competition. For example,

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Chapter 15: Prof i ts , Market Structure, and Market Power 239

faced with determined managed care negotiators, healthcare providers may merge to reduce costs and improve their bargaining positions, which can improve margins. But even when an organization cannot change a market’s competitive structure, it still has two options: It can seek to become the low-cost producer, or it can seek to differentiate its products from those of the competition. Either strategy can boost margins, even in competitive markets.

15.2 Rivalry Among Existing Firms

Most healthcare organizations have some market power. Price elasticities of demand are small enough that an organization will not lose all its business to rivals with slightly lower prices. Market power has several implications. Obvi-ously, it means firms have some discretion in pricing because the market does not dictate what they will charge. Flexibility in pricing and product specifica-tions means that managers must consider a broad range of strategies, includ-ing how to compete. Some markets have aggressive competition in price and product innovation; other markets do not. Managers have to decide what strategy best fits their circumstances. The prospect of market power also gives healthcare organizations a strong incentive to differentiate their products. The amount of market power an organization has typically depends on how much its products differ from competitors’ in terms of quality, convenience, or some other attribute.

The Effects of Increased Concentration

How have increases in market concentration among hospitals, medical groups, and health plans affected consumers? Hospital consolidation has been common since at least the early 1980s, but the implementa-tion of the Affordable Care Act restarted hospital mergers and acquisi-tions. A good deal of evidence shows that hospital prices are higher in concentrated markets, which increases out-of-pocket costs and premiums.

Evidence about the effects of consolidation on physicians’ prices is limited, but increasingly physicians are shifting into larger practices and practices that are owned by health systems. Although this consoli-dation has a number of reasons, the ability to negotiate higher prices appears to be one. For example, the price for an office visit averaged $97 for large practices but averaged $88 for small practices dealing with the same insurers (Roberts, Chernew, and McWilliams 2017).

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Healthcare organizations generally have market power because their competitors’ products are imperfect substitutes. Reasons that competitors’ products are imperfect substitutes include differences in location or other attributes, or even product familiarity. For example, a pharmacy across town is less convenient than one nearby, even if it has lower prices. Because con-sumers choose to patronize the more expensive but closer pharmacy, it has market power.

Medical goods and services are typically “experience” products, in that consumers must use a product to ascertain that it offers better value than another. For instance, patients do not know whether a new dentist will meet their needs until the first visit. Likewise, consumers must try a generic drug to be sure it works as well as the branded version. Because of this need to try out healthcare products, comparison of medical goods and services is costly, and consumers tend not to change products when price differences are small. Consumers have difficulty assessing whether experience products have good substitutes, which increases market power.

As we will see in section 15.8, advertising decisions depend on the differences that determine market power. Attribute-based differences usually demand extensive advertising. Information-based differences often reward restrictions on advertising.

Many healthcare providers have few competitors. This statement is true for hospitals and nursing homes in most markets, and often for rural physicians. Where the market is small, either because the population is small or because the service is highly specialized, competitors will usually be few. And when a firm has few rivals, all have some market power, if only because each controls a significant share of the market. Firms with few competitors recognize that they have flexibility in pricing and that what their rivals do will affect them.

15.3 Defining Market Structures

A perfectly competitive market, in which buyers and sellers are price takers (i.e., a market in which both believe that they cannot alter the market price), offers a baseline with which to contrast other market structures. In perfect competition, firms operate under the assumption that demand is very price elastic. The only way to realize above-normal profits is to be more efficient than the competition. Firms disregard the actions of their rivals, in part because potential entrants face no barriers and in part because firms have so many rivals. In any other market structure, organizations will produce less and charge higher prices.

Few healthcare markets even remotely resemble perfectly competitive markets. Some have only one supplier and are said to be monopolistic. For

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example, the only pharmacist in town is a monopolist. Other markets have many rivals, all claiming a small share of the market. At first glance these markets may look perfectly competitive, but they have one key difference: Customers do not view the services of one supplier as perfect substitutes for the services of another. Each dentist has a different location, a different personality, or a different treatment style. Firms such as these are said to be monopolistic competitors.

Firms with only a few competitors are said to be oligopolists. Firms with large market shares are also viewed as oligopolists even if they have many rivals. A local market with two hospitals serving the same area is oli-gopolistic, as is a market with 15 PPOs, the two largest of which have 40 percent of the market. Because the decisions of some competitors determine the strategies of others, oligopolistic markets differ from other markets in an important way. Oligopolists must act strategically and recognize their mutual interdependence.

15.4 Customers’ Bargaining Power

A distinguishing feature of healthcare markets has long been that they con-tain many buyers, most with limited bargaining power. Of course, in some markets a single insurer has a large market share, meaning that it has sig-nificant market power. For example, Blue Cross and Blue Shield of Alabama holds 85 percent of the individual market and 93 percent of the large group market (Kaiser Family Foundation 2016). Increasingly, insurers have sought to identify efficient providers with low prices. So, in addition to the number of sellers, healthcare market structures depend on the market shares of insur-ers (including Medicare and Medicaid, where appropriate) and the number of each in the market.

monopolistA firm with no rivals.

monopolistic competitorA firm with multiple rivals whose products are imperfect substitutes.

oligopolistA firm with only a few rivals or a firm with only a few large rivals.

Insurer Market Structure Affects Prices

Most hospitals are in markets with many insurers. In contrast, most insurers confront local markets with only a few competing hospitals or health systems. Not surprisingly, prices tend to be higher in markets in which health systems have merged and lower in markets in which a few insurers have large market shares.

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Three changes are underway that may affect negotiations between hospitals and insurers. First, insurers are merging, so concentration is increasing in some health insurance markets. Second, insurers are offering plans that exclude high-priced hospitals. These plans are called narrow networks. Third, insurers anticipate selling many more policies to individuals. They also expect that demand for these indi-vidual policies will be much more sensitive to differences in premiums. All these changes will tend to increase the bargaining power of private insurers relative to hospitals. Entry into local insurance markets at least partially offsets this gain in bargaining power. Between 2010 and 2014 hospital markets became more concentrated, but insurer markets did not (Scheffler and Arnold 2017).

(continued)

Should Governments Participate in Price Negotiations?

Cardiac catheterization, which involves inserting a long, flexible tube into an artery or vein and threading it through to the heart, is used to diagnose and treat cardiovascular conditions. Patients who are hav-ing a heart attack often receive cardiac catheterization. In the United States, the average payment negotiated by private insurers for cardiac catheterization is $5,061 (International Federation of Health Plans 2016). The average payment in Australia is $487, and the average in the United Kingdom is $4,046. The average Medicare fee for outpatient cardiac catheterization is $2,549 plus a physician fee ranging from $149 to $448 (depending on the nature of the procedure).

High private insurance prices represent a fundamental reason that healthcare is so expensive in the United States. Switzerland also has private insurance, relatively high prices, and the second highest healthcare costs in the world. However, an abdominal CT (computed tomography) scan averages $461 less in Switzerland than in the United States, a colonoscopy averages $697 less, and an appendectomy averages $9,890 less (International Federation of Health Plans 2016). With some exceptions, most healthcare prices are much higher in the

Case 15.1

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Chapter 15: Prof i ts , Market Structure, and Market Power 243

15.5 The Bargaining Power of Suppliers

The bargaining power of suppliers tends to be high when the following are true:

• The market has many buyers and few suppliers.• The supplies are differentiated, high-value products.• Suppliers can threaten to enter the industry they currently supply.• Buyers cannot threaten to manufacture supplies.• The industry is not a key customer for suppliers.

The bargaining power of suppliers varies in healthcare, even though the number of suppliers tends to be much smaller than the number of provid-ers. Some suppliers sell highly complex, highly specialized products, such as MRI (magnetic resonance imaging) equipment; others sell relatively generic

United States than in other rich countries. (This discussion is about amounts paid, not amounts charged.)

These high prices and the process that leads to them have many consequences. Out-of-pocket costs are much higher in the United States, and serious illnesses can result in medical bankruptcy. High prices increase private health insurance premiums, and many Ameri-cans cannot afford private insurance. Furthermore, private insurers increasingly rely on narrow networks of providers to get better prices. This reliance on narrow networks makes getting care more complex and can expose patients to high out-of-pocket costs if they get care from an out-of-network provider.

Discussion Questions• Why are private prices so high in the United States?

• How are commercial insurance prices set for hospital services?

• How are Medicare prices set for physicians’ services?

• How are Medicare prices set for hospital services?

• Should governments be involved in private price negotiations?

• Would consumers be better off if healthcare prices were nationally negotiated?

• Are other countries’ governments involved in healthcare pricing?

Case 15.1(continued)

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products, such as medical gloves. Most of these product lines have multiple suppliers, so pricing by suppliers tends to be competitive.

In some cases, providers may have a strong bargaining position. In markets with few providers (rural or poor areas), providers can compete with health systems in several service lines. Ambulatory surgery centers, free-standing imaging centers, and other enterprises can compete with hospitals and health systems, so providers have considerable leverage. In markets with many providers, their bargaining position is much weaker.

15.6 Entry by Potential Rivals

Barriers to entry in healthcare markets may be market based or regulation based. Generally, regulation-based barriers are more effective. Whatever the source, restrictions on entry reduce the number of competing providers and make demand less price elastic. In other words, entry restrictions, whether necessary or not, increase market power.

The best way to erect entry barriers and gain market power is to have the government do it. This strategy has two fundamental advantages. First, it is perfectly legal and eliminates public and private suits alleging antitrust violations. Second, the resulting market power is usually more permanent because government-sanctioned entry barriers will not be eroded by market competition.

State licensure forms much of the basis for market power in health-care. Licensure prevents entry by suppliers with similar qualifications and encroachments by suppliers with lesser qualifications. For example, state licensure laws typically require that pharmacy technicians work under the direct supervision of registered pharmacists and that a registered pharmacist supervise no more than two technicians. These restrictions clearly protect pharmacists’ jobs by limiting competition from technicians.

Intellectual property rights can also provide entry barriers. Innovat-ing organizations can establish a monopoly for a limited period by securing patents. A US patent gives the holder a monopoly for 17 years. The patent holder must disclose the details of the new product or process in the applica-tion but is free to exploit the patent and sell or license the rights. Patents are vitally important in the pharmaceutical industry because generic products are excluded from the market until the patent expires.

Copyrights create monopolies that protect intellectual property rights. Unlike patents, copyrights protect only a particular expression of an idea, not the idea itself. Copyright monopolies normally last for the life of the author plus 70 years. Trademarks (distinctive visual images that belong to a particular organization) also grant monopoly rights. As long as they are used

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Chapter 15: Prof i ts , Market Structure, and Market Power 245

and defended, trademarks never expire. All these legal monopolies create formidable barriers to entry for potential competitors.

Strategic actions can also prevent or slow entry by rivals. Rivals will not want to launch unprofitable ventures, and firms can try to ensure entrants will lose money. Preemption, limit pricing, innovation, and mergers are common tactics. Preemption involves moving quickly to build excess capacity in a region or product line and thereby ward off entry. For example, build-ing a hospital with excess capacity means that a second hospital would face formidable barriers. Not only would it exacerbate the capacity surplus, but this excess capacity could cause a price war. Managed care firms would not miss the opportunity to grab larger discounts. Worse still for the prospective entrant, most of the costs of the established firm are fixed. Its best strategy would be to capture as much of the market as it can by aggressive price cut-ting. In contrast, the rival’s costs are all incremental. It can avoid years of losses by building elsewhere.

Limit pricing is another tactic established firms or those with estab-lished products can use. Limit pricing means setting prices low enough to discourage potential entrants. By giving up some profits now, an organization can avoid the even bigger profit reductions that competition might cause later. In essence, the firm acts as though demand were more elastic than it is. Limit pricing only works if the firm is an aggressive innovator. Otherwise, competitors will eventually enter the market with lower costs or better qual-ity, and the payoff to limit pricing will be minimal.

Innovation by established organizations can deter entry as well. Relentless cost reductions and quality improvement means entrants will always have to play catch-up, which does not promise substantial profits.

Mergers increase market power by changing market structure. A well-conceived, well-executed merger can reduce costs or increase market power, either of which can increase profit margins. The publicized goal of most mergers is cost reductions resulting from consolidation of some functions. The accompanying anticipation of improvement in the firm’s bargaining position is usually left unspoken. Customers and suppliers usually must do business with the most powerful firms in a market. For example, failure to contract with a dominant health system will pose problems for customers and suppliers, so the system can anticipate better deals. Whether cost savings or market share gains are the more important goal of a merger is debatable.

15.7 Market Structure and Markups

Having market power does not eliminate the need to set profit-maximizing prices. Organizations should still set prices so that marginal revenue equals

preemption Building excess capacity in a market to discourage potential entrants.

limit pricingSetting prices low enough to discourage entry into a market.

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marginal cost. If the return on equity is inadequate, the organization should exit the line of business.

15.7.1 MarkupsWhat changes with a gain in market power is markups. A firm with substantial market power will find it profitable to set prices well above marginal cost. Exhibit 15.1 shows that a firm with a substantial amount of market power (ε = −2.5) will have a 67 percent markup. In contrast, a firm with a moder-ate amount of market power (ε = −7.5) will only have a 15 percent markup. Finally, a firm with little market power (ε = −12.0) will have a 9 percent markup.

Organizations with market power benefit from markup. However, their customers face higher prices, which results in their using the product less or not at all. As a result, managers’ goals depend on whether they are buying or selling. Managers seek to reduce their suppliers’ market power while increasing their own. If your suppliers have substantial market power and you have none, your profit margins will suffer.

Market Share

Market Elasticity

Firm’s Elasticity

Marginal Cost

Profit- Maximizing Price

48% –0.60 –1.25 $10.00 $50.00

24% –0.60 –2.50 $10.00 $16.67

7.5% –0.60 –8.00 $10.00 $11.43

5% –0.60 –12.00 $10.00 $10.91

EXHIBIT 15.1Market Share and Markups

Mergers Result in Price Increases

Between 2000 and 2016 more than 2,500 hospital mergers and acqui-sitions took place, meaning that the consolidation of hospital markets continues (American Hospital Association 2016). In principle, the merger of two hospitals allows cost savings. The merged hospitals would need less excess capacity to cope with spikes in demand, could avoid duplicate services, and could share some overhead expenses. Schmitt (2017) estimates that acquired hospitals reduce their costs by an average of 7 percent over a four-year period, but these savings only occur when hospitals are acquired by a system. (The acquiring hospital

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15.7.2 The Impact of Market Structure on PricesEconomists often use the Hirschman-Herfindahl Index (HHI) to identify concentrated markets. The HHI equals the sum of the squared market shares of the competitors in a market. The HHI gets larger as the number of firms gets smaller or as the market shares of the largest firms increase. For example, a market with five firms, each with 20 percent of the market, would have an HHI of 2,000. In contrast, a market with five firms, four of which each claimed 15 percent of the market while the fifth claimed 40 percent, would have an HHI of 2,500. A higher HHI usually results in higher prices. For example, a study by Baker and colleagues (2014) found that private insurers paid cardiologists $63 for an office visit in counties with an HHI of 2,176 but paid $78 in counties with an HHI of 4,275.

Attributes other than market power can also result in high markups. White, Reschovsky, and Bond (2014) point out that, in addition to having a

Hirschman-Herfindahl Index (HHI) A measure used to identify concentrated markets. (The HHI equals the squared market shares of firms in a market. For example, if firms had market shares of 40, 30, 20, and 10, the HHI would be 3,000 = 1,600 + 900 + 400 + 100. A potential source of confusion is that some calculations treat a 40% market share as 0.40 and others treat it as 40. This book uses the second approach.)

concentrated market A market with few competitors or a few dominant firms.

or system does not appear to experience cost reductions.) For the most part, hospitals that are acquired by other hospitals in the same local market do not reduce their costs, suggesting that other motives matter as well.

The other motive for consolidation is to increase market power. A single hospital or a two-hospital system is in a much better bargaining position than two independent hospitals serving the same area. For example, Dauda (2018) concludes that the merger of two hospitals in a market with five hospitals would result in substantial price increases.

Recognizing that hospital consolidations could push prices up, federal antitrust authorities have opposed some hospital mergers. The authorities have lost most of these suits. Courts have generally seen the not-for-profit status of merging hospitals as a guarantee of price restraint, although the economics literature provides little support for this expectation.

On the contrary, most studies have found that merged not-for-profit hospitals significantly increase prices (Gaynor, Ho, and Town 2015), but the effects of mergers depend on the nature of the hospitals and the nature of the competition in their market. The literature sug-gests that if two small hospitals in a competitive market merge, their ability to negotiate higher prices will be limited. In contrast, if two large hospitals in a smaller market merge, their ability to negotiate can be substantial.

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large market share, providing specialized services, having a good reputation, and being a member of a system also result in higher prices.

15.8 Market Power and Profits

Market power does not guarantee profits. A firm with market power will set prices well above marginal cost but may not earn an adequate return on equity. However, firms with market power can use strategies to boost profits that firms without market power cannot.

Three competitive strategies are common among firms with market power: price discrimination, collusion, and product differentiation. We discussed price discrimination in chapter 12; in this chapter we will focus on collusion and product differentiation.

15.8.1 CollusionCollusion, or conspiring to limit competition, has a long history in medicine. As in other industries, the temptation to avoid the rigors of market competi-tion can be beguiling. Collusion is profitable because demand is less elastic for the profession than for each individual participant. For example, if the price elasticity of demand for physicians’ services is about −0.20 and the price elasticity of demand for an individual physician’s services is about −3.00, an individual physician can earn a greater income by cutting prices, yet raising prices will increase the income of the profession as a whole.

Exhibit 15.2 shows how a 10 percent price increase would change total revenue for organizations facing different elasticities. (The change in total revenue due to a price cut equals [percentage change in price + percent-age change in quantity] + [percentage change in price × percentage change in quantity].) For the profession as a whole, raising prices will increase revenues because demand is inelastic. For each individual professional, raising prices

price discrimination Selling similar products to different buyers at different prices.

collusionA secret agreement between parties for a fraudulent, illegal, or deceitful purpose.

product differentiation The process of distinguishing a product from others.

Price Increase Elasticity Quantity Change Revenue Change

10% −0.1 −1% 8.9%

10% −0.2 −2% 7.8%

10% −0.3 −3% 6.7%

10% −3.0 −30% −23.0%

10% −3.5 −35% −28.5%

10% −4.0 −40% −34.0%

EXHIBIT 15.2Elasticity

and Revenue Changes

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will reduce revenues unless other professionals change their prices, which would make demand less elastic. Of course, others are likely to respond to price cuts by cutting their own prices, so revenues will climb far less than a naïve analysis would suggest.

The implication of exhibit 15.2 is that physicians as a group would increase their incomes if they refused to give discounts to managed care organizations. What is good for the profession, however, is not what is good for its individual members. Individual physicians would be tempted to decry managed care discounts but make private deals with HMOs. From the per-spective of the profession, penalizing defectors would prevent this problem.

In the 1930s, Oregon physicians did just that. Faced with an oversup-ply of physicians, excess capacity in the state’s hospitals, and widespread con-cern about the costs of healthcare, insurance companies in Oregon attempted to restrict use of physicians’ services. Medical societies in Oregon responded by threatening to expel physicians who participated in these insurance plans. Because membership in a county medical society was usually a requirement for hospital privileges, this response was a serious threat. This threat and phy-sicians’ ultimate refusal to deal with insurance companies led the insurers to abandon efforts to restrict use of physicians’ services (Starr 1982).

In most industries these steps would be recognized as illegal, anticom-petitive activities. However, the belief that antitrust laws did not apply to the medical profession was widespread until a 1982 Supreme Court decision to the contrary. Since then the Federal Trade Commission has sued to prevent boycotts of insurers, efforts to deny hospital privileges to participants in managed care plans, and attempts to restrict advertising. In short, healthcare professionals and healthcare organizations are treated no differently than other businesses.

The benefits of collusion are clear. By restricting competition, firms can reduce the price elasticity of demand and increase markups. Collusion only increases profits, however, until it is detected.

15.8.2 Product Differentiation and AdvertisingProduct differentiation takes two forms: attribute based and information based. In attribute-based product differentiation, customers recognize that two products have different attributes, even though they are fairly close substitutes, and may not respond to small price differences. In information-based product differentiation, customers have incomplete information about how well products suit their needs. Information is expensive to gather and verify, so customers are reluctant to switch products once they have iden-tified one that is acceptable. Both forms reduce the price elasticity of demand for a product and create market power (Caves and Williamson 1985).

attribute-based product differentiation Making customers aware of differences among products.

information-based product differentiation Making customers aware of a product’s popularity, reputation, or other signals that suggest high value.

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Both attribute-based and information-based product differentiation are common in healthcare. For example, a board-certified pediatrician who practices on the west side of town clearly provides a service that is different from a board-certified pediatrician who practices on the east side of town. If the two practices were closer together, more customers would view them as equivalent. Alternatively, armed only with a sense that the technical skills, interpersonal skills, and prices of surgeons can vary significantly, a potential customer who has found an acceptable surgeon is not likely to switch just because a neighbor was charged a lower fee for the same procedure. Of course, the customer might be more likely to switch if complication rates, patient satisfaction scores, and prices for both surgeons were posted on the Internet for easy comparison.

The role of information differs sharply in attribute-based and information- based product differentiation. Extensive advertising makes sense for products that differ in attributes that matter to consumers. The more clearly customers see the differences, the less elastic demand will be and the higher markups can be for “better” products. In contrast, restrictions on advertising (and even restrictions on disclosure of information) make sense in situations with information-based product differentiation. The harder it is for customers to see that products do not differ in ways that matter to them, the less elastic demand will be and the higher markups can be.

The coexistence of attribute-based and information-based product dif-ferentiation in healthcare leads to confusing advertising patterns. Attribute-based product differentiation demands advertising. Getting information about product differences into the hands of customers is integral to this type of product differentiation. For example, pharmaceutical manufacturers have launched extensive direct-to-consumer advertising campaigns. On the other hand, better customer information erodes the market power created by information-based product differentiation. Where information-based prod-uct differentiation is common, as it is in much of healthcare, a temptation to restrict advertising is present. Because private restrictions on advertising are usually illegal, the most successful limits have been based in state law.

Despite these divergent incentives, advertising has increased in recent years. One reason has been court rulings that professional societies cannot limit advertising. However, advertising has also increased in some sectors—such as inpatient care—where advertising has long been legal. The real driv-ing force seems to be increased competition for patients.

The nature of healthcare products and the nature of healthcare mar-kets combine to make advertising more common. Most healthcare firms have market power and competition to some degree. Advertising helps differenti-ate one product from another, so it increases margins. In monopoly markets (e.g., the only hospital in an isolated town), product differentiation is not

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useful. The provider already has high margins, and advertising is unlikely to increase them. In markets with many providers (e.g., retailers of over-the-counter pain medications), margins may be low, but differentiating one seller from another is difficult and advertising expenditures will be unlikely to increase revenues.

Patients cannot easily assess the quality of most healthcare goods and services before using them. Because of this fact, advertising can perform a useful service, that of giving consumers information they would have dif-ficulty getting otherwise. If consumers gained no information from adver-tising, they would probably ignore it. Having information about a product differentiates it from products about which one does not have information. Providers who offer exceptional values also need to advertise to ensure that consumers are aware of their low prices or high quality. Studies of advertising in healthcare generally find that banning advertising results in higher prices. Indeed, increasing price transparency represents one strategy for reducing healthcare prices (Reinhardt 2013).

The economic logic behind advertising and innovating is simple: Con-tinue as long as the increase in revenue is greater than the increase in cost. Stop when marginal revenue from advertising or product differentiation just equals the marginal costs. This logic differs from the standard rule only in that the cost of differentiation (advertising or innovating) is included in the marginal costs. Exhibit 15.3 shows the calculations organizations need to consider. Suppose the firm starts with profits of $100,000. In case 1 it antici-pates that incremental advertising costs of $10,000 will allow it to increase revenues by $50,000. Because the incremental costs of production are only $30,000, spending more on advertising makes sense in case 1. In case 2 the firm has the same production cost forecasts but anticipates that it will need to spend $22,000 on advertising to increase revenues by $50,000. The higher advertising costs in case 2 mean that an attempt to increase sales would be unprofitable. As long as the incremental costs of production and advertising are less than incremental revenue, increasing advertising will increase profits. Managers need to take into account both advertising and production costs. Advertising only makes sense for products with significant margins.

Incremental Revenue

Incremental Costs

ProfitProduction Advertising

Baseline $100,000

Case 1 $50,000 $30,000 $10,000 $110,000

Case 2 $50,000 $30,000 $22,000 $98,000

EXHIBIT 15.3Advertising and Profits

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Economics for Healthcare Managers252

The profit-maximizing amount of advertising is determined by con-sumers’ responses to advertising and prices. The profit-maximizing rule is that advertising costs (measured as a percentage of sales) should equal −α/ε. In other words, an organization will maximize profits when its ratio of advertising to sales equals −1 times the ratio of the advertising elasticity of demand, −α, to the price elasticity of demand, ε. The advertising elasticity of demand is the percentage increase in the quantity demanded when adver-tising expenses increase by 1 percent. Obviously, advertising that does not increase sales is not worth doing. Firms with less elastic demand will want to spend more on advertising. A firm with an advertising elasticity of demand of 0.1 should spend 2.5 percent of its revenues on advertising if its price elas-ticity of demand is −4.00, but another firm with an advertising elasticity of demand of 0.1 should spend 5 percent of revenues on advertising if its price elasticity of demand is −2.00.

Product differentiation (through innovation or advertising) is a pro-cess, not an outcome. Differentiation, although potentially profitable, tends to erode. Product differentiation can be clear-cut (e.g., an open MRI facil-ity), less distinguishable (e.g., “patient-centered care”), barely noticeable (e.g., “meals that do not taste like hospital food”), emotional (e.g., “doctors who care”), or frivolous (e.g., stripes in tooth gel). In all these instances, however, successful differentiation asks to be copied and generally is, neces-sitating ceaseless efforts to differentiate products.

Deregulating Pharmaceutical Advertising

Among wealthy countries, only the United States and New Zealand allow direct-to-consumer prescription pharmaceutical advertising. The value of direct-to-consumer advertising of prescription drugs is widely debated, as are its effects on prescription sales and costs. Direct-to-consumer advertising on television started in 1997, when the Food and Drug Administration authorized it.

The case against direct-to-consumer advertising is that consumers lack the expertise to make informed decisions about prescription med-ications and that only expensive, branded products will be advertised, creating barriers to entry for generic products. The case for direct-to-consumer advertising is that it provides consumers with information

Case 15.2

(continued)

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Chapter 15: Prof i ts , Market Structure, and Market Power 253

15.9 Conclusion

Most healthcare firms have some market power. Market power allows higher markups and can result in higher profits. As a result, firms try to acquire mar-ket power or defend the market power they have. The best way to acquire or defend market power is via regulation. Competitors find it more difficult to erode market power gained as a result of government action.

Organizations can take steps to gain market power without govern-ment action. Common strategies include preemption, limit pricing, and innovation, all of which are designed to discourage potential entrants. Merg-ers can also result in market power, as can collusion with rivals. Unlike other strategies for gaining market power, mergers and collusion often create legal problems. Mergers may result in public or private antitrust lawsuits, as does collusion once it has been discovered.

Firms with market power can compete in a variety of ways. Where fea-sible, firms seek to gain market power via product differentiation and adver-tising. This situation makes managers’ roles more challenging. Of course, the profit potential of market power creates an incentive to seek it, even without a guarantee of profits.

about products that have been rigorously reviewed for safety and effectiveness. Examples of such information include more convenient dosing,

reduced side effects, and fewer interactions. From another perspective, pharmaceutical companies use advertis-

ing to differentiate their products and increase margins.

Discussion Questions• How could advertising be a barrier to entry?

• Could advertising reduce barriers to entry for a new product?

• Presumably drug companies are trying to differentiate their products from the competition. Will consumers be better off or worse off if the companies succeed?

• Consumers generally favor direct-to-consumer advertising, and healthcare professionals generally oppose it. Does this difference in attitudes make sense?

• Should direct-to-consumer advertising be banned?

Case 15.2(continued)

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Economics for Healthcare Managers254

Exercises

15.1 What does it mean to have market power? Are firms with market power extremely profitable?

15.2 Can you identify a healthcare firm with market power? What characteristics led you to choose the firm that you did?

15.3 Why would a merger reduce costs? Why would a merger increase markups? Why do many mergers fail nonetheless?

15.4 What information would you like to have when planning advertising spending?

15.5 Why might banning advertising drive up prices? 15.6 Offer examples of attribute-based product differentiation and

information-based product differentiation. 15.7 Two physical therapy firms want to merge. The price elasticity

of demand for physical therapy is −0.40. Firm A has a volume of 10,400, fixed costs of $50,000, marginal costs of $20, and a market share of 8 percent. Firm B has a volume of 15,600, fixed costs of $60,000, marginal costs of $20, and a market share of 12 percent. The merged firm has a volume of 26,000, fixed costs of $100,000, marginal costs of $20, and a market share of 20 percent.a. What are the total costs, prices, revenues, and profits for each

firm and for the merged firm?b. How does the merger affect markups and profits?

15.8 A local hospital offered to buy firm A in exercise 15.7 for $5,000, and the offer was refused. However, many observers now perceive that firm A is “in play” and may be sold if the right offer comes along.a. In successful transactions, purchasers have typically paid ten times

current profits. How much would firm A be worth to a buyer from outside the industry?

b. Would you expect that firm B would be willing to pay more or less than an outside buyer?

c. What is the most firm B would be willing to pay for firm A? 15.9 Two clinics want to merge. The price elasticity of demand is −0.20,

and each clinic has fixed costs of $60,000. One clinic has a volume of 7,200, marginal costs of $60, and a market share of 2 percent. The other clinic has a volume of 10,800, marginal costs of $60, and a market share of 4 percent. The merged firm would have a volume of 18,000, fixed costs of $80,000, marginal costs of $60, and a market share of 6 percent.a. What are the total costs, revenues, and profits for each clinic and

for the merged firm?

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Chapter 15: Prof i ts , Market Structure, and Market Power 255

b. How does the merger affect markups and profits? 15.10 What would each of the clinics in exercise 15.9 be worth to an

outside buyer (using the guideline of ten times annual profits)? What would each of the clinics be worth to each other?

15.11 A hospital anticipates that spending $100,000 on an advertising campaign will increase bed days by 1,000. The marketing department anticipates that each additional bed day will yield $2,000 in additional revenue and will increase costs by $1,200. Should the hospital proceed with the advertising campaign?

15.12 A clinic is considering reducing its advertising budget by $20,000. The clinic forecasts that visits will drop by 100 as a result. Costs are $140 per visit and revenues are $180 per visit. Should the clinic reduce its advertising budget?

15.13 The price elasticity of demand for dental services is −0.25. In a market with 100 dentists, the local dental society demanded and received an 8 percent increase in prices from the dominant dental insurance company. What should happen to the dentists’ revenues and profits? (Assume that average costs equal marginal costs.) Would this agreement be stable? Explain.

15.14 The marginal cost of a physician visit is $40. In a county with 50 physicians, the local medical society negotiated a rate of $90. Previously, any physician who offered discounts to an insurer or a patient could be cited for unethical behavior, be expelled from the medical society, and lose admitting privileges to the county’s sole hospital. But having lost an antitrust lawsuit, the medical society has agreed to stop enforcing its prohibitions against discounting, to allow any physician with a valid license to be a member of the medical society, and to stop linking admitting privileges to medical society membership.a. The price elasticity of demand for physicians’ services is −0.18.

What price maximizes profits for the individual physicians in the county?

b. If all the physicians act independently, will their incomes go up or down?

c. Is there any way the physicians could legally act to sustain a price of $90?

15.15 Harvoni is a lifesaving medication for people with hepatitis C. A four-week supply averaged $32,114 for privately insured patients in the United States in 2015. In Switzerland the price was $16,861. Why are the prices so different? Should the government intervene to reduce the price? How might the government intervene?

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